Technical Overview: Head and Shoulder Continuation Pattern

After shrugging off overbought indicators left and right and likewise ignoring extreme bullish sentiment measures the equity market finally succumbed to a top in February 2011. Since then the equity markets have entered into a congestion pattern with a short and shallow retracement.

It is important to note that the major uptrend is still in effect. This is true for the medium term (from the September 2010 lows) as it is for the long term (from the March 2009 lows). In the case of the long term trendline the angle is a bit less steep. In either case the corresponding current level for the S&P 500 is 1275-1285. This level is obviously an important area to watch as a decisive break below this trendline would mean a complete change in the tone of the market.

Amid the confusion of this sideways market, there is another technical pattern that may be emerging. This is the lesser known diamond pattern about which Edwards and McGee write in their seminal work, “Technical Analysis of Stock Trends“:

Although it is fairly conspicuous and easily detected when it appears on the charts, the Diamond is not a common pattern. Since its development requires fairly active markets, it rarely occurs at Bottom Reversals. Its “natural habitat” is Major Tops and the High-Volume Tops which precede extensive Intermediate Reactions.

You’ll notice that I haven’t drawn the diamond in the chart. This is partly because as a matter of personal preference I don’t really like diamond formations; they are after all, complex head and shoulder formations with a V-shaped neckline instead of the usual straight line. Also to draw it would make the chart look too busy and confusing. I try to keep things simple so let’s revert back to the simpler formation and look at the emerging head and shoulder formation on the S&P 500 index.

The head and shoulder formation in technical analysis is probably one of the most commonly known because it is the first to be taught to students. In fact, it is the first technical pattern presented by Edwards and McGee. Of course, it is presented as a reversal pattern that occurs either at tops or bottoms to signal a major trend change in price.

But head and shoulder formations are also continuation patterns. Near the last bear market low I outlined that there is one distinction between head and shoulder reversal and continuation or consolidation patterns. To quote the masters again, here is what Edwards and McGee say on this subject:

All our references to the Head-and-Shoulder Formations up to this point have considered that pattern as typifying Reversal of Trend, and in its normal and common manifestation, that is ost definitely the Head-and-Shoulder function. But occasionally, prices will go through a series of fluctuations which construct a sort of inverted Head-and-Shoulders picture which in turn leads to continuation of the previous trend.

There is no danger of confusing such Continuation or Consolidation Formations with regular Head-and-Shoulders Reversals because, as we have said, they are inverted or abnormal with respect to the direction of the price trend prior to their appearance. In other words, one of these patterns which develops in a rising market will take the form of a Head-and-Shoulders Bottom. Those that appear in declines, assume the appearance of a Head-and-Shoulders Top. By the time thse price formations are compelted (left shoulder, head and right shoulder evident), there is no question as to their implications. But at the head stage, before the right shoulder is constructed, there may be – usually is – considerable doubt as to what is really going on.

To put it simply, if we are in a rising trend, the head and shoulders formation would be a consolidation or continuation pattern if it were to take the shape of a W. That is in fact what we have on the S&P 500 right now. Or more precisely, are about to have if the right shoulder completes as it looks like it will.

Today’s close carved a bullish hammer candlestick right where we would need prices to stop going down to create the right shoulder. If prices continue to hold at this point and then break above 1335-1340 that would be a bullish development as the neckline would have been breached to the upside and the continuation pattern would be in place. As well, the rising uptrend that I mentioned at the beginning would have been maintained.

And if prices don’t follow that script, but instead continue in a sideways consolidation or break below the trendline, that itself will also tell us quite a bit about the market going forward. Personally, I’m expecting the head and shoulder continuation pattern to complete but I’ll be watching the final push up to provide important information in terms of the breadth that underlies that rally.

I hope that provides you with some food for thought and some patterns and levels to watch this week.

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3 Responses to Technical Overview: Head and Shoulder Continuation Pattern

  1. OntheMoney says:

    So let’s assume the bull market continues.

    A breakout of the inverse head and shoulders would appear to target roughly 1400 on the S&P. If such a move higher represented an Elliot wave 5 – assuming wave 4 is the correction from February into mid-March – it suggests a major bull market peak occuring well before the end of the year.

    Interestingly, this fits with a contrarian outlook for China and emerging market stocks, which have been leading our own by some months. It seems they may be approaching an unexpected, significant, imminent top.

    • DrBohica says:

      Wasn’t Mr Elliot Wave himself predicting the big fallout last Fall, then last Winter? What is up with the patience awarded to this technique? Whatever happens, it seems ultimately to be according to prophesy of Elliot Wave, although followers have missed big bucks through massive, extremely protracted long bull runs. Something seems to be very wrong with this technique.

      • OntheMoney says:

        Valid point, Dr. Elliot wave is a tool I never use dogmatically but it can be useful to give a broad idea of where we likely are in a bigger picture.

        ‘Three pushes to a high/low’ is a phenomenon clearly observable in all time frames and is soundly based in investor psychology. The problem comes when you format rigid rules and attempt to trade them in real time rather than hindsight and, for me, this subjectivity makes it pretty much unusable for daily trading purposes.

        Nevertheless, our bull market appears to have enjoyed three (maybe four) strong pushes higher from the low in July 2010. Powerful breadth thrusts have accompanied each of these moves. In addition, sentiment readings for stocks (in fact almost all risk assets) are touching extremes seen at the two most recent bull market tops, as Babak’s analysis is now showing here every week. To me, these are blinding red flags I have no interest in ignoring.

        I’m certainly not fighting the price action right now, which strongly suggests a continuation of the thrust higher from mid-March and a push to new S&P highs. In the above link, however, there is unusual technical evidence pointing to an imminent major top in emerging markets.

        Since they have been excellent lead indicators for our own, a reversal in Hong Kong, Australia and elsewhere would imply that serious trouble for our markets – never mind for commodities – won’t be too far behind.

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